The highly anticipated FED stress test results may very well serve as fuel for further gains or, more likely in my opinion, as a sought after excuse for turning the tide (in the short run).

The idea of stress testing is an intuitive one. You test something to determine whether or not it is able to withstand various types of shocks without falling apart. The recent financial crisis has brought the issue of stress testing of financial institutions, predominantly banks, closer to the public eye but what really lies behind these stress tests?The notion of capital adequacy
Banks and other financial institutions are, in their basic form, mediators of money accepting deposits from the public on one hand and issuing credit on the other. Banks earn, again very basically, from a financial spread between the interest rate of credit issued to that paid on deposits accepted. As any other corporation the net of a bank’s asset and liabilities is the bank’s capital.

This capital plays a very significant role in assuring the soundness and viability of a bank as it can be perceived as a cushion, of sorts, which absorbs various losses the bank may have due to the risks involved in its operations.

Regretfully, I don’t have to explain the importance the soundness and viability of the banking system has in any economy. Therefore, the capital held by banks is highly regulated by the government.

Any company, when bankrupt, may cause heavy losses to its close economic environment. But the companies that were in business with the bankrupt company had, or should have had the ability to manage the risks in doing business with that particular company and were compensated for that risks by profits generated through that business.

When a bank goes bankrupt the general public, which had trusted the bank to be conservative enough to keep the deposit side intact, suffers. The public has very little in the way of tools to ensure and manage the risks in their dealings with banks (other than carefully choosing our bank).

Capital adequacy in banks is therefore highly important and closely monitored. A bank should have, in essence, adequate capital to cover the risks it incurs in its lending and financing operations.

Risks are abundant in banks and include mainly the credit risk incurred in lending activities of not being repaid by the lender but also significant market risks due to the financial nature of the business and significant operational risks due to the complexity of banks’ operations.
Banks are also exposed to many other risks such as legal risks, liquidity risk, business risk, reputational risk and endless others.How is capital adequacy regulated?
In order to regulate capital adequacy very detailed requirements of how a bank should handle its capital are issued by regulators everywhere. The most famous of these regulations are the Basel regulations published by the Basel committee of the Bank for International Settlements (BIS) which is an international organization that promotes international cooperation in monetary and financial issues and which central banks turn to for regulatory guidance and insight.

The regulation regarding capital adequacy issued by the BIS are known as Basel I and Basel II and contain detailed requirements and guidance on capital adequacy.

Essentially, this guidance break down the bank’s off and on balance sheet items and translates these items into what are known as Risk Weighted Assets (RWA) where each asset receives a certain weighting dependant on the risk associated with it.

For example, a US government bond will receive a negligible risk weight while credit issued to a non-ranked company will be weighted as 100% risky asset. These risk weighted assets are than summed to receive the total risk weighted assets of the bank and are translated into a capital requirement accordingly.

The regulation is very detailed and includes requirements both on the risk weighted asset side and the capital side. Banks cannot recognize, for example, any sort of capital as regulatory capital for the purpose of demonstrating capital adequacy.

Banks are expected to have capital buffers which are excess capital a bank holds, over the regulatory requirements, to withstand unexpected risks and scenarios.

The problem, as we’ve experienced, begins when banks get involved in business that has not yet received proper regulatory treatment. This issue will always be an open issue as regulators usually react to market developments, thus always lagging behind.

For the purpose of calculating capital adequacy a detailed and common segmentation of business is published and regulated by the regulator. When something does not fit the mold it usually receives a treatment that is not necessarily appropriate or no treatment at all.

This is how financial crisis spring to life.What are stress tests?
Stress tests are tests performed by banks and regulators to examine the capital adequacy of a bank under various stressed scenarios which may present difficulties for the bank’s business. The goal of the stress test is to examine whether a bank has sufficient capital buffers to withstand the impact certain economic and business scenarios may have on it.

Stress tests are conducted by banks on a routine basis to make sure they can adequately handle adverse changes in their business and positions in the market and withstand any reasonable impact unexpected materializations of risks may have.

The results of stress tests serve banks in determining the capital buffer they should hold, as a function of the banks conservatism and regulatory environment.

Most regulators have published specific generic scenarios banks should use for stress testing their capital adequacy. These include adverse market conditions, usually in the form of combinations of historic worse case macro-economic parameters. This, however, is not enough.
Banks must adopt stress tests which specifically target the weakest points in the bank’s strategy and balance sheet to ensure the viability of the bank’s business in more turbulent times.

For example, in a utopian world banks that issues complex financial instruments would have considered the ramifications a liquidity problem may cause thus limiting this once very profitable business. Alas, we are not living in a utopian world and banks went bankrupt for all intents and purposes only to be bailed out by the government.

facilitating the development of risk mitigation or contingency plans across a range of stressed conditions.

Stress tests are a very important tool for risk management in banks and serve many aspects of it as demonstrated above.The Supervisory Capital Assessment Program – The Fed’s stress tests
The FED has conducted stress tests in the biggest banks in the US to determine their capital adequacy and the adequacy of their capital buffers under the current crisis. The NY times had published the guidance on How to Design and Conduct a Bank Stress Test as released by the FED.

The results are highly expected in the market and will be published in May, 4. So far the Fed had hardly commented on the results of the tests conducted.
The scenarios examined include changes in Real GDP, unemployment rate and housing prices.Black Swans – The problem with stress tests

Conducting stress tests is very much like preparing future wars based on the experience gathered in past wars. Future wars will always be different and scenarios will always be surprising.

There are two basic types of stress tests: Historically based stress tests which are essentially worst case scenarios and User defined stress tests which are more fitted to each bank but are usually limited to the imagination of banks and, again, their experience.

The black swan theory, which has gained increased popularity in the recent crisis, targets the key weakness of stress tests. The black swan theory argues, in this context, that models cannot capture hard to predict, large scale and rare events which are exactly the events that shape our world and our financial markets (like the recent crisis).

Model must assume certain distributions and assumptions and will always miss on something. Usually the even they were built to capture.Awaiting the results
The stock market anxiously awaits the results of stress tests and their impact on the capital of the largest banks in the US. It is important to note that failing a stress test does not mean the bank is bankrupt, or in trouble. It is a measure of how prepared banks are to handle adverse economic situations.

I believe the results will be highly ambiguous and will be taken by the markets depending on sentiment. If market plays want to sell the results will be interpreted as terrible and if a continuation of the recent rally is in order that the results will be surprisingly good.

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This blog is about my personal opinions which are based on my financial education. My posts and articles are to be regarded with the appropriate sceptisism and should under no circumstances be used to replace professional financial assistance.